Britain took a step into uncharted territory this year, aiming to make its banks safer. But it might have just driven risk to places where it’s less manageable than before.
The experiment — the result of an analysis of how the financial crisis damaged Britain’s economy — began Jan. 1. Big lenders were "ring-fenced": retail deposit-taking was legally separated from riskier activities, primarily investment banking. Advocates compared ring-fencing to the U.S. Glass-Steagall act, passed after the 1929 crash.
Britain’s big international players, Barclays Plc and HSBC Holdings Plc, are now barred from moving much of their domestic earnings into their international arms. However, they’ve used the trapped capital to start a price war in home mortgages. That’s hurt the small lenders the government hoped would thrive post-crisis — and driven some of them to extend questionable credit to make a profit.
“The fundamental problem is that risk is being pushed out from the center,” said Stephen Jones, chief executive of UK Finance, the industry lobby group. “Banks that are able to lend very cheaply are at the lowest end of the risk spectrum, and that is driving the high-funding-cost, non-ring-fenced banks to make the riskier loans. There is potentially quite a dangerous cocktail of conflicting regulation and consequences building up.”
The escalating risk comes against the backdrop of Britain’s impending exit from the European Union. However, while Brexit has weighed on the bigger lenders and slowed investment, ring-fencing has been more disruptive in the domestic banking scene. For the small banks, the message has been clear: get bigger, get specialized, or get out of there.
Smaller lenders grew quickly in mortgage lending to “niche borrowers” to “gain a foothold in the market,” Fitch Ratings said earlier this year. Small banks also drew the attention of the Bank of England — which today named Andrew Bailey, head of the Financial Conduct Authority, the top financial regulator, as its next governor.
The BOE examined 20 smaller banks and found a series of problems. While not calling them out by name, the central bank warned “fast-growing firms” had “concentrations in higher-risk market segments which may be more vulnerable to stress.”
It also said poor controls meant firms could be masking the true levels of bad debts, and highlighted weaknesses in their underwriting standards.
The U.S. considered ring-fencing but chose the Dodd-Frank reforms instead. The European Union also decided against it. The U.K.‘s lonely path is gathering critics at home.
“It has given rise to a competitive monster” in mortgages, said Paul Lynam, who runs Secure Trust Bank Plc, whose products include specialist real estate and car loans. “It will ultimately create an extremely polarized market, with big banks at one end and small niche lenders at the other end, with nothing in the middle.” He said regulators could “trim the wings” of the ring-fenced banks by requiring them to set aside more capital against a mortgage.
Two banks that grew out of supermarket chains show the trend. Seven years after it first began offering mortgages, Tesco Plc’s Tesco Bank said in May that it would exit the business, citing “challenging market conditions.” It sold its entire portfolio to Lloyds Banking Group Plc, the U.K.’s largest mortgage lender. Sainsbury’s Bank, owned by J Sainsbury Plc, is in the process of selling its mortgage book.
Metro Bank Plc, founded by U.S. entrepreneur Vernon Hill, is reviewing its mortgage business as part of its wider restructuring. Secure Trust stopped making residential home loans this year.
Customer-owned lenders that provide savings and mortgage products are also hurting. Joe Garner, chief executive officer of the largest one, Nationwide Building Society, complains that the regulation is distorting the market.
"There are some competitors who are ring-fenced and have got effectively trapped liabilities, and therefore they’ve got, if anything, too much by way of deposit,” and are offering low interest rates to savers as a result, he said. "The competitive dynamic in mortgages is visible. The one in savings is not as visible as it should be."
The architect of ring-fencing is John Vickers, an Oxford University academic and former chief economist of the Bank of England. He led the Independent Commission on Banking that recommended the regulation, and stands by its conclusions.
"We thought quite hard about the dangers," he said, repeating that the main thrust was to avoid a repeat of the taxpayer rescues of 2008-09. As for the unintended consequences in the mortgage market, he notes the upside.
"From a consumer point of view, more competition is great," Vickers said. "When people talk about too much competition, I always twitch."
